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No. 07-1526

 

In the Supreme Court of the United States

CEMCO INVESTORS, LLC, ET AL., PETITIONERS

v.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

GREGORY G. GARRE
Acting Solicitor General
Counsel of Record
GILBERT S. ROTHENBERG
Acting Assistant Attorney
General
RICHARD FARBER
ARTHUR T. CATTERALL
Attorneys
Department of Justice
Washington, D.C. 20530-0001
(202) 514-2217

QUESTIONS PRESENTED

1. Whether the court of appeals correctly held that 26 C.F.R. 1.752-6 applies retroactively to petitioners' transactions.

2. Whether the court of appeals correctly rejected petitioners' argument that 26 U.S.C. 6662, which pro vides for penalties when a taxpayer misstates "the value of any property (or the adjusted basis of any property)" by more than a certain percentage, applies to a misstate ment of basis only if a misstatement of value is "embed ded" in that misstatement of basis.

In the Supreme Court of the United States

No. 07-1526

CEMCO INVESTORS, LLC, ET AL., PETITIONERS

v.

UNITED STATES OF AMERICA

ON PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT

BRIEF FOR THE UNITED STATES IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. 1-10) is reported at 515 F.3d 749. The opinion of the district court (Pet. App. 11-35) is unreported.

JURISDICTION

The judgment of the court of appeals was entered on February 7, 2008. On April 4, 2008, Justice Stevens ex tended the time within which to file a petition for a writ of certiorari to and including June 6, 2008, and the peti tion was filed on that date. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1).

STATEMENT

1. On August 13, 2000, the Internal Revenue Service (IRS) issued Notice 2000-44, 2000-2 C.B. 255, which alerted taxpayers that certain transactions designed to create artificially high bases in partnership interests in order to manufacture artificial losses were ineffective for federal tax purposes. Pet. App. 20. The notice stated that losses claimed based on those transactions could be challenged under, inter alia, 26 U.S.C. 752, which addresses the proper treatment of liabilities by partners and partnerships. Pet. App. 22. The notice also stated that taxpayers who claim losses based on the transactions could be subject to accuracy-related penal ties under 26 U.S.C. 6662, including penalties for mis stating the value or adjusted basis of property. Pet. App. 22.1

More than three months later, Paul M. Daugerdas, a tax lawyer whose promotion of basis-inflating tax shel ters of the sort described in Notice 2000-44 led to the demise of Jenkens & Gilchrist, P.C., implemented one of those shelters for the benefit of himself and a client. Pet. App. 2, 13-15. Daugerdas utilized three entities for the shelter (in addition to a wholly-owned entity through which he held his share of the other three entities): Cemco Investors, LLC (Cemco), Cemco Investment Partners (the Partnership), and Cemco Investors Trust (the Trust). Id. at 13.

On December 4, 2000, the Trust purported to pay Deutsche Bank (the Bank) a premium of $3.6 million for the right to receive $7.2 million from the Bank if the dollar-to-euro exchange rate was less than or equal to $.8652 per euro on December 19, 2000; simultaneously, the Bank purported to pay the Trust a premium of $3.564 million for the right to receive $7.128 million from the Trust if the dollar-to-euro exchange rate was less than or equal to $.8650 per euro on that date. Pet. App. 2-3, 14. The offsetting premium "payments" for the op tion contracts were effected by a transfer from the Trust to the Bank of $36,000 (the difference between $3.6 mil lion and $3.564 million). Id. at 3. The Bank promised to refund $30,000 of that $36,000 if the option contracts offset each other on the exercise date. Ibid. On Decem ber 5, 2000, the Trust assigned its contractual right to the Partnership, which in turn assumed the Trust's cor responding contractual obligation. Id. at 14-15.

On December 18, 2000, the Partnership purchased just under 56,000 euros for $50,000. Pet. App. 3, 15. The next day, the option contracts offset each other, and the Bank refunded $30,000 to the Partnership. Ibid. The Partnership liquidated two days later, distributing the euros and some leftover cash to the Trust. Ibid.

On December 26, 2000, the Trust transferred the euros to Cemco. Pet. App. 15. Three days later, Cemco sold the euros for approximately $51,325. Ibid. Cemco reported a loss of approximately $3,563,212 from this sale on its 2000 tax return, even though the Partnership had purchased the euros for only $50,000 eleven days before Cemco sold them for $51,325. Ibid. The claimed loss is based on the theory that, in determining the Trust's basis in the Partnership (its outside basis), the payment side of the transactions must be taken into ac count, while the offsetting obligation side must be ig nored because of its allegedly contingent nature. Id. at 15-16, 23. Thus, the Trust claimed an aggregate basis in the Partnership of approximately $3.6 million for an in vestment of only $36,000. That disconnect ultimately led to Cemco's claimed loss of approximately $3,563,212 on the sale of the euros, even though the out-of-pocket costs of its principals were approximately $6000.2

The IRS disallowed the claimed loss on various grounds, including that, under Section 752 and its imple menting regulations, the obligation side of the transac tions had to be treated as a liability that reduced the Trust's outside basis in the Partnership. See Pet. App. 17; Pet. C.A. App. A62. The IRS also determined that Cemco's underpayment of tax was subject to penalties under Section 6662, including the 40% penalty for egre gious misstatements of value or basis (gross valuation misstatements). Id. at A62-A63; see 26 U.S.C. 6662(h).

2. Petitioners sought review of the IRS's determina tions in the United States District Court for the North ern District of Illinois. Pet. App. 12. The district court granted summary judgment in favor of the United States. Id. at 11-35.

The district court held that Cemco's claimed loss was precluded by 26 C.F.R. 1.752-6. Pet. App. 20-31. That regulation was promulgated, initially in temporary form, on June 24, 2003, to implement the IRS's position, ex pressed in Notice 2000-44, that losses generated by tax shelters like the one utilized by petitioners are inconsis tent with Section 752. Id. at 5-6, 22. The district court explained that the regulation makes clear that, when, in connection with a partner's contribution of property to a partnership, the partnership assumes the partner's obligation to make a payment, whether fixed or contin gent, that obligation must be reflected as a reduction in the partner's outside basis. See id. at 22-23. The court further noted that the regulation by its terms applies to transactions, such as petitioners', which occurred be tween October 19, 1999, and June 23, 2003. See ibid. (citing 26 C.F.R. 1.752-6(d)).3

Petitioners acknowledged that the regulation disal lowed losses of the type that Cemco claimed, Pet. App. 23, and they did not argue that the regulation could not be applied retroactively to the transactions at issue, see id. at 25 & n.6. Instead, petitioners argued that the IRS could not disallow Cemco's claimed loss because the IRS could adjust the basis of the euros only by issuing a no tice of adjustment to the Partnership, and, absent such a notice, Cemco was required to use the basis assigned to the euros by the Partnership. See id. at 24-31. The district court rejected those arguments. See ibid.

The district court also rejected petitioners' challenge to the valuation misstatement penalties. Pet. App. 31- 35. Section 6662 provides for penalties when an under payment of tax is "attributable to," among other things, a "substantial valuation misstatement" or a "gross valu ation misstatement[]." 26 U.S.C. 6662(b) and (h). As the district court explained, "a substantial valuation mis statement occurs when 'the value of any property (or the adjusted basis of any property) claimed on any return of tax . . . is 200 percent or more of the amount deter mined to be the correct amount of such valuation or ad justed basis (as the case may be).'" Pet. App. 32 (quot ing 26 U.S.C. 6662(e)(1)(A)). The definition of "gross valuation misstatement," the court further explained, is the same, except that the penalty is increased to 40% and the amount claimed on the tax return must be 400% or more of the correct value or adjusted basis. Ibid.

Petitioners argued that "a misstatement of 'adjusted basis' should be punishable under section 6662 only if a misstatement of value 'is embedded in [the] misstate ment of adjusted basis.'" Pet. App. 33 (quoting Pet. Br. in Supp. of Mot. for Partial Summ. J. 15). According to petitioners, that interpretation of the statute was required because of the parentheses around the phrase "or the adjusted basis of any property" in Section 6662(e)(1)(A). See ibid. The district court rejected peti tioner's interpretation as contrary to "the clear statu tory language." Ibid. The court observed that, "[w]hile Cemco makes a valiant effort to overcome the language of section 6662, it has included nothing in its briefs to indicate that an interpretation such as it describes was intended." Id. at 33-34.

3. The court of appeals affirmed the district court's judgment. Pet. App. 1-10. After describing the transac tions that petitioners had used to generate their claimed loss (id. at 1-4), and noting that "[t]he deal as a whole seems to lack economic substance" (id. at 4), the court considered and rejected petitioners' argument that Sec tion 1.752-6 may not be applied retroactively to their transactions. Id. at 5-8. The court explained that "[t]he regulation could not be more explicit" that it "applies to assumptions of liabilities," like petitioners', "occurring after October 18, 1999, and before June 24, 2003." Id. at 6 (quoting 26 C.F.R. 1.752-6(d)(1)). The court acknowl edged that, under 26 U.S.C. 7805(b)(1), IRS regulations "generally do not apply to transactions" that predate publication of the regulations. Pet. App. 6. The court noted, however, that, under the plain terms of Section 7805(b)(6), "the norm of prospective application 'may be superseded by a legislative grant from Congress autho rizing the Secretary to prescribe the effective date with respect to any regulation.'" Id. at 6-7 (quoting 26 U.S.C. 7805(b)(6)). The Court further explained that Congress had authorized the Secretary to prescribe an effective date for the regulation in this case in Section 309 of the Community Renewal Tax Relief Act of 2000 (2000 Act), Pub. L. No. 106-554, 114 Stat. 2763A-638. Pet. App. 7. That statute, the court explained, enacted basis-reduc tion rules for many transactions and authorized the IRS to adopt regulations prescribing similar rules for part nerships and to make those regulations retroactive to October 18, 1999. See ibid.

The court of appeals stated that one district court, in Klamath Strategic Inv. Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006), appeal pending, No. 07-40861 (5th Cir. filed Sept. 7, 2007), had concluded that the retroactivity of Section 1.752-6 cannot rest on the 2000 Act because the IRS had not availed itself of that authority in promulgating the regulation. Pet. App. 7. The court of appeals concluded, however, that the IRS had clearly relied on the authority provided by the 2000 Act because the IRS had chosen October 18, 1999, as the effective date for the regulation. Ibid.

The court therefore held that Section "1.752-6 ap plies to this deal and prevents Cemco's investors from claiming a loss." Pet. App. 7. The court observed that "Cemco is scarcely in a position to complain-not only because this tax shelter was constructed after the warn ing in Notice 2000-44, but also because all the regulation does is instantiate the pre-existing norm that transac tions with no economic substance don't reduce people's taxes." Id. at 7-8.

The court of appeals also rejected petitioners' re newed arguments that the IRS could not disallow Cemco's claimed loss because the IRS could adjust the basis of the euros only by issuing a notice of adjustment to the Partnership, and, absent such a notice, Cemco was required to use the basis assigned to the euros by the Partnership. Pet. App. 8-10. Petitioners also renewed their argument that "a misstatement of adjusted basis is not within the scope of the penalty" provisions of Sec tion 6662 "unless a misstatement of valuation is embed ded in that misstatement of adjusted basis." Pet. C.A. Br. 38. The court of appeals rejected that argument without addressing it in the opinion.

ARGUMENT

Petitioners contend that this Court's review is war ranted because, "[t]hrough its decision below, the Sev enth Circuit entered both a three-way circuit split on the meaning of the economic substance doctrine and a two- way split on the meaning of the valuation-misstatement penalty statute." Pet. 11. Contrary to that contention, the court of appeals did not take a position on either of the circuit conflicts identified by petitioners. Instead, the decision below rested on other grounds, which the court of appeals decided correctly and which petitioners have not challenged in their petition for a writ of certio rari. Accordingly, this Court's review is not warranted.

1. a. Petitioners err in contending that "the Seventh Circuit subtly adopted a view of the [economic sub stance] doctrine that conflicts with the holdings of at least five other circuits." Pet. 12. On the contrary, nei ther the district court nor the court of appeals rested its judgment on the economic substance doctrine, the appli cation of which entails a fact-laden inquiry. Instead, the district court held that Cemco's claimed loss was pre cluded by Section 1.752-6, a mechanical basis-reduction rule that obviates the need for any factual inquiry into the subject transactions' economic substance. Pet. App. 20-25. The court of appeals agreed, rejecting petition ers' argument that the regulation could not validly be applied retroactively to petitioners' transactions. Id. at 5-7.

The court of appeals did not rest its decision on the economic substance doctrine, much less silently take sides in a disagreement about the contours of that doc trine. Petitioners' contention that it did (Pet. 11-12, 17- 18) is based entirely on two isolated sentences of dicta in the court's opinion. Petitioners rely on the court's passing statement that "[t]he deal as a whole seems to lack economic substance." Pet. 11-12 (emphasis omit ted) (quoting Pet. App. 4). But the court made that statement, which does not even take a conclusive posi tion on whether the transactions lacked economic sub stance, in describing the facts of the case and before addressing the legal issues. See Pet. App. 4. Petitioners also rely on the court's statement that Section 1.752-6 merely served to "instantiate the pre-existing norm that transactions with no economic substance don't reduce people's taxes." Pet. 12 (quoting Pet. App. 7-8). But the court made that statement after it had already held that Section "1.752-6 applies to this deal and prevents Cem co's investors from claiming a loss." Pet. App. 7. Be cause the court of appeals' decision did not rest on the economic substance doctrine, this case does not present the Court with an opportunity to resolve any disagree ment among the courts of appeals in their approach to that doctrine.

b. The actual holding of the court of appeals-that Section 1.752-6 validly applies retroactively to petition ers' transactions-is correct and does not warrant re view. As the court of appeals explained, Section 1.752-6 expressly states that it "applies to assumptions of liabili ties," like petitioners', "occurring after October 18, 1999, and before June 24, 2003." Pet. App. 6 (quoting 26 C.F.R. 1.752-6(d)(1)). Although IRS regulations "gen erally do not apply to transactions" that predate publica tion of the regulations, see 26 U.S.C. 7805(b)(1), that limitation on retroactive application "may be superseded by a legislative grant from Congress authorizing the Secretary [of the Treasury] to prescribe the effec tive date with respect to any regulation," 26 U.S.C. 7805(b)(6). As the court of appeals concluded, the Secre tary's decision to prescribe an effective date for Section 1.752-6 was authorized by Section 309 of the 2000 Act, 114 Stat. 2763A-638. Pet. App. 7. That statute pre scribed basis-reduction rules for many transactions and authorized the IRS both to adopt regulations prescrib ing similar rules for partnerships and to make those regulations retroactive to October 18, 1999. See ibid.

Petitioners incorrectly criticize the court of appeals for failing to conduct what petitioners term a "conven tional retroactivity analysis" (Pet. 12) of the kind con ducted in Snap-Drape, Inc. v. Commissioner, 98 F.3d 194 (5th Cir. 1996), cert. denied, 522 U.S. 821 (1997). See Pet. 12, 21-22. The analysis in Snap-Drape and sim ilar cases, dealing with retroactive regulations issued pursuant to a prior version of 26 U.S.C. 7805(b) (1994), has no application to retroactive regulations issued pur suant to Section 7805(b)(6), which was enacted in 1996.

In Snap-Drape, the Fifth Circuit applied a four- factor test-based largely on fairness concerns, includ ing whether the taxpayer had justifiably relied on prior law-in reviewing the Commissioner's promulgation of a retroactive regulation pursuant to the pre-1996 version of Section 7805(b). See 98 F.3d at 202. Under that version of Section 7805(b), the Commissioner generally was authorized to issue retroactive regula tions, subject to judicial review for abuse of discretion. See, e.g., Gehl Co. v. Commissioner, 795 F.2d 1324, 1332 (7th Cir. 1986). In 1996, however, Congress entirely revised the Commissioner's authority to issue retro active regulations. See Taxpayer Bill of Rights 2, Pub. L. No. 104-168, § 1101(a), 110 Stat. 1468. As amended, Section 7805(b) now generally prohibits the Commissioner from issuing retroactive regulations. See 26 U.S.C. 7805(b)(1). There are, however, specific ex ceptions to the general prohibition against retroactivity, see 26 U.S.C. 7805(b), and, as the court of appeals cor rectly held (Pet. App. 6-7), the Commissioner relied on one of those exceptions here-a legislative grant of au thority to prescribe a regulation's effective date, 26 U.S.C. 7805(b)(6).

When the Commissioner promulgates a retroactive regulation pursuant to a specific legislative grant of au thority, that action is not subject to judicial review for abuse of discretion because it is expressly authorized by Section 7805(b)(6). Instead, a reviewing court is limited to determining whether, as a matter of law, the regula tion falls within the scope of the legislative grant of au thority. That is precisely the determination that the Seventh Circuit made in the decision below, and peti tioners have not challenged that determination in this Court. Accordingly, the court of appeals' decision that Cemco is not entitled to its claimed loss does not war rant this Court's review.

2. Petitioners' request for review of the court of ap peals' ruling affirming the penalties under Section 6662 is similarly misconceived. Petitioners incorrectly con tend (Pet. 22-31) that this case presents this Court with the opportunity to resolve a disagreement among the courts of appeals over the scope of Section 6662. Con trary to that contention, the decision below does not im plicate the disagreement identified by petitioners. And petitioners have not challenged the actual holding of the court of appeals on the penalty issue.

a. The disagreement among the courts of appeals identified by petitioners actually concerns the scope of 26 U.S.C. 6659 (1988), the now-repealed predecessor to Section 6662. Similar to Section 6662, that section pro vided for penalties for certain underpayments of tax when those tax underpayments were "attributable to" a valuation overstatement. 26 U.S.C. 6659(a) (1988) (re pealed 1989). The disagreement concerns whether an underpayment of tax is "attributable to" an overstate ment of value or basis in situations where deductions or credits premised on the overstated value or basis are disallowed in their entirety based on some other rule or doctrine. Compare, e.g., Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988) (valuation misstatement penalty not applicable to underpayment resulting from disallow ance of depreciation deductions and investment tax credits based on taxpayers' failure to place the subject assets in service during the year in issue), with Massengill v. Commissioner, 876 F.2d 616 (8th Cir. 1989) (valuation misstatement penalty applicable to underpayments resulting from disallowance of deprecia tion deductions and investment tax credits based on tax payers' failure to acquire tax ownership of the subject assets under economic substance doctrine).

Even assuming that the courts that disagree over the scope of Section 6659 would have the same disagreement about the scope of Section 6662 (which also contains the phrase "attributable to"), that disagreement is not impli cated by this case. Petitioners assert that, "[b]y reject ing Cemco's challenge to the valuation misstatement penalty, the Seventh Circuit implicitly sided with those courts that take a broad view" of when an underpayment is "attributable to" a misstatement of value or basis. Pet. 25. That assertion is incorrect. Petitioners never argued in the court of appeals that Cemco's understate ment of tax was not "attributable to" a misstatement of value or basis because Cemco's basis in the euros was eliminated based on Section 1.752-6. Nor did petition ers' briefs in the court of appeals allude to any disagree ment among the courts of appeals on the scope of the penalty provisions, much less urge the court of appeals to "t[ake] sides" in that disagreement. Pet. 22. Peti tioner's sole argument on the penalty issue was that "a misstatement of adjusted basis is not within the scope of the penalty unless a misstatement of valuation is embed ded in that misstatement of adjusted basis." Pet. C.A. Br. 38; see id. at 33-41; see Pet. C.A. Reply Br. 18-20. By rejecting that argument, the court of appeals did not express any view on the disagreement among the courts of appeals that petitioner now asks this Court to resolve. Accordingly, this case does not present an opportunity for the Court to resolve that disagreement.

Petitioners insist that the penalty issue raised in their petition for a writ of certiorari is properly pre sented because "Cemco argued, both before the district and circuit courts, that the IRS could not apply § 6662 against it," and "the traditional 'pressed or passed upon' rule for granting certiorari requires only that a claim be 'pressed' or 'passed upon,' not both." Pet. 25 (quoting United States v. Williams, 504 U.S. 36, 41 (1992)). But Williams articulates the "pressed or passed upon" rule in terms of issues or questions presented, not "claim[s]." Although Cemco certainly pressed below its generalized claim that "the IRS could not apply § 6662 against it," ibid., it did not, as discussed above, press the issue that is the subject of the "longstanding circuit split" (ibid.) that petitioners now ask this Court to resolve (i.e., whether an underpayment is "attributable to" an over statement of value or basis when deductions or credits premised on the overstated value or basis are disallowed in their entirety for some other reason). That issue was neither pressed nor passed upon by the court of appeals, and it is not properly before this Court.

b. The penalty issue that the court of appeals did resolve also does not warrant this Court's review. By affirming the district court's judgment upholding the valuation misstatement penalty, the court of appeals implicitly rejected petitioners' argument that basis over statements are subject to Section 6662 penalties only if they involve an "embedded" valuation misstatement. The court of appeals was correct to reject that argu ment, which, as the district court explained (Pet. App. 32-34), is contrary to Section 6662's plain text. See 26 U.S.C. 6662(e)(1)(A) (treating misstatements of "the value of any property" and misstatements of "the ad justed basis of any property" interchangeably). Indeed, the court of appeals apparently did not even consider the argument worth addressing in its opinion, and peti tioners have not renewed the argument in their petition for a writ of certiorari. Accordingly, there is no reason for this Court to consider it.

CONCLUSION

The petition for a writ of certiorari should be denied.

Respectfully submitted.

GREGORY G. GARRE
Acting Solicitor General
GILBERT S. ROTHENBERG
Acting Assistant Attorney
General
RICHARD FARBER
ARTHUR T. CATTERALL
Attorneys

 

 

AUGUST 2008

1 Unless otherwise indicated, all references in this brief to the rele vant statutory provisions are to the 2000 edition of the United States Code. Although there have been some changes to the provisions since that time, they do not affect the legal analysis of the case.

2 The purchase and sale of the euros was a necessary part of the scheme because, under 26 U.S.C. 732(b), a partner's outside basis attaches to any property distributed to him in kind in liquidation of his interest. The euros served as "property" to which the Trust's inflated outside basis in the Partnership could attach.

3 A much more detailed set of rules applies to transactions occurring on or after June 24, 2003. See 26 C.F.R. 1.752-7.